FINANCIAL MARKETS

Final Exam: Chapters 6 - 9

PRICING

CHAPTER 6 ● Priced at a discount from their par value

● Depends on the investor’s required rate of
return
MONEY MARKET SECURITIES ● Value is present value of the par value

- Debt securities with one year or less

maturity
- Issued in the primary market for short-term
financing
- Can be sold in the secondary market
- Liquid

➢ Treasury (government programs) AUCTION

➢ Corporations (support and expand ● Competitively
business) - Purchase large amounts
➢ Households (cars, homes, credit cards,
etc)
➢ Financial intermediaries (corporations and ● Noncompetitive
households) - Has a limit of $5 million per auction

YIELD
TREASURY BILLS

- Issued by the government

- 4, 13, 26 week maturities on a weekly basis
- Minimum of $1,000 (historically,
$10,000)
- Sold at a discount value from par
- Gain = par value - price paid
- Free of credit risk
Example:
- Highly liquid with strong secondary market

INVESTORS
● Depository Institutions
- Accommodate withdrawals

● Financial Institutions
- When cash outflows exceed inflows
DISCOUNT

● Individuals
- Substantial savings
- Invests through money market funds

● Corporations
- Cover unanticipated expenses Example:
FINANCIAL MARKETS
Final Exam: Chapters 6 - 9
REPURCHASE AGREEMENTS
COMMERCIAL PAPER
- One party sells securities to another with an
- Issued by well-known, creditworthy firms agreement to repurchase it at a specified
- Unsecured date and price (reverse repo: purchases)
- Provide liquidity or finance an investment in - Loan backed by the securities
inventory and accounts receivable - Financial institutions often participate
- Minimum is $100,000 - Minimum of $10 million
- 20 days, 45 days, 1 day, and 270 days - 1 day to 15 days for 1, 3, and 6 months

● Junk Commercial Paper YIELD

- Rated low or not rated at all

YIELD: 360 days

FEDERAL FUNDS

- Depository institutions lend or borrow

short-term funds
Example: - Rate is slightly higher than the Treasury bill
- Commercial banks are active participants

● Federal Reserve
- Adjusts the amount of funds in depository
institutions to influence the federal funds

NEGOTIABLE CERTIFICATES OF DEPOSIT

BANKER’S ACCEPTANCES
- Issued by large commercial banks and
depository institutions
- Accepts responsibility for a future payment
- Has secondary market
- International trade transactions
- Minimum is $100,000
- Active secondary market exists
- 2 weeks to 1 year

YIELD
FINANCIAL MARKETS
Final Exam: Chapters 6 - 9
MUNICIPAL BONDS
INTEREST RATE RISK
- Issued by state and local governments
- Interest rate, increases
Required rate of return, increases
Price, decreases ● General Obligation Bonds
- Supported by the municipal government’s
ability to tax

CHAPTER 7 ● Revenue Bonds

- Supported by the revenue of projects where
BACKGROUND ON BONDS bonds were issued

- Long-term debt securities

- Government or corporations
-
- Issuer is obliged to pay interest (coupon)
periodically and par value at maturity CORPORATE BONDS
- Issued in the primary market
- 10 to 30 years
- Issued by corporations
- Minimum is $1,000
- 10 to 30 years maturity
● Bearer Bonds
- require the owner to clip coupons attached
to the bonds and send them to the issuer to
OFFERINGS
receive coupon payments
● Public Offering
- Underwriters place newly issued bonds with
institutional investors
● Registered Bonds
- require the issuer to maintain records of
who owns the bond and automatically send
● Private Placement
coupon payments to the owners
- Small firms
- Insurance companies, pension funds, and
YIELDS
bond mutual funds

● Issuer’s Perspective
- Measured to maturity
CHARACTERISTICS
- Future coupon and principal payments to
● Sinking Fund Provision
the initial proceeds received from the bond
- requirement that the firm retire a certain
offering
amount of the bond issue each year

● Investor’s Perspective
● Protective Covenants
- Holding period return
- restrictions placed on the issuing firm
- to protect bondholders from being exposed
➢ Coupon payments
to increasing risk during the investment
➢ Par value to pay - price received when
period
selling

● Call Provisions
TREASURY AND FEDERAL AGENCY BONDS - Price above par value

➢ Call Premium
- Finance federal government expenditures
- Call price - Par Value
- Minimum $100
- 10 years
- Received semiannual interest payments
from the treasury
FINANCIAL MARKETS
Final Exam: Chapters 6 - 9
TYPES OF LONG-TERM DEBT
● Bond Collateral 1. Structured Notes
- amount of interest and principal to be paid
is based on specified market conditions
● Low and zero-coupon bonds
- Deep discount from par value
- Tax-exempt investment accounts 2. Exchange-traded notes
- issuer promises to pay a return based on
the performance of a specific debt index
● Variable Rate Bonds - 10 to 30 years maturities
- Coupon rate is periodically adjusted

3. Auction-rate securities
● Convertibility - way for borrowers (e.g., municipalities and
- Allows investors to exchange the bond for a student loan organizations) to borrow for
stated number of shares of the firm’s long-term periods while relying on a series
common stock of short-term investments by investors
- Every 7 to 35 days, the securities can be
auctioned off to other investors
● Default Rate
- General level of defaults on corporate bonds
is a function of economic conditions

● Bond Ratings
CHAPTER 8
- Higher ratings
Higher prices BOND VALUATION PROCESS
Lower yields
CURRENT PRICE (PV)

SECONDARY MARKET
1. Corporate Bond Listing

2. Types of Orders

➢ Market Order
- transaction will occur at the prevailing
market price

➢ Limit Order
- transaction will occur only if the price
reaches the specified limit
Example:

3. Trading Online

JUNK BONDS
- High risk
- Mutual funds, life insurance companies, and
pension funds
- High risk securities have higher discount
rates
FINANCIAL MARKETS
Final Exam: Chapters 6 - 9

CHAPTER 9
RELATIONSHIP BETWEEN COUPON RATE,
REQUIRED RATE, AND BOND PRICE
BACKGROUND ON MORTGAGES

1. Discount Bonds (PV < 1,000)

- Debt to finance a real estate investment
- Sells/price is below par
- 15 to 30 years
- Coupon rate is below the required rate

➢ Mortgage rate
➢ Maturity
2. Par Bonds (PV = 1,000)
➢ Collateral
- Sells/price is equal to par
- Coupon rate equals required rate

3. Premium Bonds (PV > 1,000)

- Sells/price above par
- Coupon rate is above the required rate

FACTORS AFFECTING RISK-FREE RATE

1. Inflationary Expectations (INF)

- Level of inflation, increases
Interest rate and required rate of return, CRITERIA IN MEASURING
upward pressure CREDITWORTHINESS
- Vice versa
1. Level of equity invested
- Low investment results to higher probability
2. Economic Growth (ECON) of default
- Growth, strong
Interest rate, upward pressure
➢ Loan-to-value ratio
- indicates the proportion of the property’s
3. Money Supply (MS) value that is financed with debt
- Money supply, increases
Interest rate, downward pressure
Bond prices, increases 2. Income Level
- lower level of income are more likely to
default
4. Budget Deficit (DEF)
- Budget deficit, increases
Interest rate, upward pressure 3. Credit History
- Borrowers with a history of credit problems
are more likely to default

FACTORS AFFECTING CREDIT RISK

PREMIUM

- Change in economic growth

- Economic growth, strong
Default, reduce the probability
- Vice versa
FINANCIAL MARKETS
Final Exam: Chapters 6 - 9
4. Growing-equity Mortgages
- Monthly payments are initially low and
CLASSIFICATION OF MORTGAGES
increase over time
- The payments never level off but continue
● Prime Mortgages to increase throughout the life of the loan
- borrower meets traditional lending
standards
5. Second Mortgages
- Conjunction with the primary or first
● Subprime Mortgages mortgage
- borrower does not quality for prime loan

➢ Relatively lower income 6. Shared-appreciation Mortgages

➢ High existing debt - allows a home purchaser to obtain a
➢ Can make only a small down payment mortgage at a below-market interest rate
- In return, the lender will share in the price
appreciation of the home
● Insured Mortgages
- loan is insured by FHA or VA
7. Balloon Payment Mortgages
- Requires only interest payments for a 3 to 5
● Conventional Mortgages year period
- loan is not insured by FHA or VA but can be - At the end of this period, the borrower must
privately insured pay the full amount of the principal

TYPES OF RESIDENTIAL MORTGAGES RISKS IN MORTGAGES

1. Fixed-rate Mortgages ● Credit Risk

- locks in the borrower’s interest rate over the - borrower will make a late payment or will
life of the mortgage default
- exposed to interest rate risk because it
commonly uses funds obtained from
short-term customer ● Interest Rate Risk
- Borrowers with fixed-rate mortgages do not - value of mortgage will fall when interest
suffer from rising rates, but benefit from rates rise
declining rates

● Prepayment Risk
2. Adjustable-rate Mortgages - borrower will prepay the mortgage when
- mortgage interest rate to adjust to market interest rates fall
conditions
- specify a precise formula
- contain a clause that allow the borrower to
switch to a fixed rate within a specified
period

3. Graduated-payment Mortgages
- Allows the borrower to make small
payments initially on the mortgage
- payments increase on a graduated basis
over the first 5 to 10 years and then level
off
FINANCIAL MARKETS
Final Exam: Chapters 6 - 9
VENTURE CAPITAL MARKET
- It brings together the private businesses
MORTGAGES-BACKED SECURITIES
that need equity funding and the VC funds
that can provide funding.
● Securitization - venture capital conferences, proposals
- pooling and repackaging of loans into
securities, then sold to investors
TERMS OF A VENTURE CAPITAL DEAL
- amount of funds it is willing to invest, terms,
THE SECURITIZATION PROCESS requirements
- The VC fund managers may serve as
1. A financial institution such as a securities advisers to the business.
firm or commercial bank combines individual
mortgages together into packages.
EXIT STRATEGY OF VC FUNDS
2. The issuer of the MBS assigns a trustee to - A VC fund typically plans to exit from its
hold the mortgages as collateral for the original investment within about 4 to 7
investors who purchase the securities. years.

3. After the securities are sold, the financial ➢ sell its equity stake to the public, if it goes
institution that issued the MBS receives public
interest and principal payments on the ➢ may cash out if the company is acquired by
mortgages and then transfers (passes another firm
through) the payments to investors that
purchased the securities
PERFORMANCE OF VC FUNDS
- In periods when stock prices are low, VC
funds can invest their money more wisely in
CHAPTER 10 companies, and therefore have a better
chance of earning decent returns.
- However, when stock prices are high, VC
PRIVATE EQUITY funds may pay too much when investing in
companies.
- owners cannot sell their shares to the public - They might receive more funds, they are
- A public offering of stock may be feasible more likely to compete with each other to
only if the firm will have a large enough buy companies, and the bidding will cause
shareholder base to support an active them to pay a higher premium for the
secondary market. company.
- When VC funds receive more limited
funds, they can focus only on the most
FINANCING BY VENTURE CAPITAL FUNDS desirable investments, and are less likely to
pay too much when investing in companies.
- Private firms that need a large equity
investment but are not yet in a position to
go public FINANCING BY PRIVATE EQUITY FUNDS
- 5 or 10 years
- The VC fund commonly serves as a bridge - It pools equity funding provided by
for financing the business until it either goes institutional investors (such as pension
public or is acquired funds and insurance companies) and invests
- Investors are not allowed to withdraw their in businesses.
money before a specified deadline. - It commonly takes over businesses and
manages them.
- They pursue companies that are overvalued
and mismanaged (in their opinion), because
they can more easily achieve a high return
on their investment when buying weak firms
that they can improve.
FINANCIAL MARKETS
Final Exam: Chapters 6 - 9

- take a percentage of the profits they earn

from their investments and charge an
annual fee

➢ Sell their stake in the business

➢ IMPROVE THE BUSINESS: sell their stake
to another firm for a higher price or take the
business into public through an Initial Public
Offering (IPO).

PERFORMANCE OF PRIVATE EQUITY FUNDS

OWNERSHIP AND VOTING RIGHTS
- Private equity funds invest their funds more
wisely in companies when stock prices are
generally low. - Shareholders rely on the firm’s managers to
- However, if stock prices are very high, serve as agents and to make decisions in
private equity funds may be subject to large the shareholders’ best interests.
losses (if stock market conditions - The ownership of common stock entitles
deteriorate) even if they can improve shareholders to a number of rights not
operations. available to other individuals.
- Private equity funds may be especially prone
to making bad investments when they ➢ election of the board of directors
receive large amounts of funds from ➢ authorization to issue new shares of
investors, and pursue more investments common stock
than are feasible. ➢ approval of amendments to the corporate
- Conversely, when they receive more charter
limited funds, they can more carefully ➢ adoption of bylaws
screen their potential targets, and are more
likely to make feasible investments

PREFERRED STOCK

PUBLIC EQUITY - does not allow for significant voting rights

- share the ownership of the firm with
- When a firm goes public, it issues stock in common shareholders
the primary market in exchange for cash. - compensated only when earnings have been
- They can obtain financing to support the generated
firm’s growth - PAID FIRST
- They can “cash out” by selling their original - represents a permanent source of financing
equity investment to others

➢ Stock - certificate representing partial

ownership in the firm. PARTICIPATION IN STOCK MARKETS

- Common stock is issued by firms in the

- The investment by individuals in a large
primary market and the purchaser becomes
corporation commonly exceeds 50 percent
a part owner of the firm.
of the total equity.
- Owners of stock can benefit from the
growth in the value of the firm, however,
they are also susceptible to large losses.
FINANCIAL MARKETS
Final Exam: Chapters 6 - 9

INVESTOR RELIANCE ON INFORMATION

- Favorable news about a firm’s performance

will make investors believe that the firm’s
stock is undervalued at its prevailing price
(demand increases and upward
pressure on stock price).

(vice versa)

INITIAL PUBLIC OFFERINGS

- A first-time offering of shares by a specific

firm to the public.
- to obtain new funding and offer some
founders and VC funds a way to cash out
their investment
- At Least $50 million